5 ETF Options Trades to Play the Market Recovery

Three bullish and two bearish ETF option strategies to play

The market has spent the last three months flashing signs that a recovery may indeed be underway, though you wouldn’t know it from the daily trading volume. It still appears that retail investors have yet to engage the market. From our perspective, the market is still flashing signs that our year-end target of 1,500 for the S&P 500 is still well within the realm of possible outcomes.

The market’s first-quarter uptrend was fueled by fairly consistent signs of improvement in our domestic economy. At the same time, rhetoric surrounding the Eurozone and Greece died down to a level that was less distracting from the domestic economy for the bulls. The result of this environment was a powerful improvement to the technical picture for stocks as the market’s trend has once again become investor’s friend.

Last week’s employment data — a figure that came in at about half of the expected 200,000 jobs created — was the first disappointment thrown the market’s direction in some time. The news is almost certain to get some bulls in the selling mood as they lock in some of their lofty year-to-date gains.

That said, the pullback may better be described as a buying opportunity for those that have been stuck on the sidelines waiting for an opportunity. Well, the current stall in the major indices may be just the opportunity that sidelined bulls have been waiting to pounce on, meaning we could be looking at the next buying opportunity for stocks.

With all of this in mind, let’s take a look at a few of our favorite sectors to lead the market higher through 2012 and a few options positions to help you leverage that strength.

Trade #1: XRT

Retail activity is the lifeblood of our economy, so it shouldn’t be a big surprise to you when you hear this is one of the perennial leadership sectors when the market starts a long-term rebound. According to our research, the SPDR S&P Retail ETF (NYSE:XRT) typically rallies almost two times as strong as the S&P 500 out of intermediate-term bottoms when a recovery rally is underway. Our research suggests the XRT may finish 2012 around $73.

Based on the expected performance, the average investor might consider a position in the XRT as an “alpha generator” for their portfolio as the retail sector is likely to lead the market higher through 2012. For those investors that are looking to leverage the Retail sector’s leadership, let’s consider a few options.

For those looking to add some leverage to their portfolio, the XRT January 2013 65 call, priced at about $3.10, offers a long-term conservative options strategy. At its current level, you’re risking $310 per contract with potential for an option that would have an intrinsic value of $800 per contract if our target price is right. The position would net a return of more than 150% with those assumptions.

Trade #2: XLY

The consumer Discretionary sector has been one of the resilient stories through the market’s trials as many of the higher-end brands have been able to maintain their strength. This strength should remain in place as the economy improves and consumers increase their activity with companies such as Target (NYSE:TGT), McDonald’s (NYSE:MCD) and Home Depot (NYSE:HD). Similar to the Retail sector, the Consumer Discretionary stocks tend to outpace the S&P 500 Index’s moves by two-fold when the market is bouncing back from being in a bear market. As such, a year-end target of $50 would be reasonable.

At their current prices, the at-the-money SPDR Consumer Discretionary Select Sector Fund ETF (NYSE:XLY) January 2013 45 calls offer a great leveraged position for this outlook. Based on the current price of $3.00 per contract, the option has the potential to appreciate by more than 150% if the ETF hits our year-end target. Even more if the underlying shares were to hit that target before year-end.

For those more aggressive traders, the out-of-the-money XLY January 2013 48 calls, valued around $1, offer a potential for higher returns. The potential payout for this option increases to 400% based on the target of $53, though the risks of coming-up empty-handed if the market reverses course increases given that the option is currently out-of-the-money.

Trade #3: KBE

The market has seen its share of “Zero to Hero” trades over the last year, including the illustrious return of the Financial sector back to its current market leadership. Given the toxic situation that these stocks were in a few years ago, the “crowd” hasn’t wanted much to do with these issues. This means the performance turnaround in the group has caught many by surprise.

The surprise is apparent in the current analyst ranking data for the SPDR KBW Bank ETF (NYSE:KBE), which shows that banking stocks like JP Morgan (NYSE:JPM), Bank of America (NYSE:BAC) and Citigroup (NYSE:C) are among the least-recommended stocks by Wall Street Analysts.

As of this week, our analyst rank data shows that Banking and Regional Banking ETFs are among the least recommended when you consider the analyst ranking of the component companies of the ETF.
Click to Enlarge They say the best time to buy is when everyone else is selling. Well, according to the analyst rankings, the Regional Bank ETF is one of the ETFs with the most sell ratings on its component stocks. We always like buying a technical performer when the analyst community is still on the sell side as it suggests we’re likely to see upgrades on the horizon, which means even higher prices. Given the slingshot effect that may happen when these upgrades occur, it’s not outside of reason to target a price of $32 for the Regional Bank ETF shares. The KBE January 2013 25 call is now on sale for under $1.50 per contract, giving the aggressive trader the opportunity to bank a potential “triple-hit” if the KBE shares were to trade as high as our targeted $32 before expiration.

Trade #4: XOP

SPDR S&P Oil & Gas Exploration & Production ETF (NYSE:XOP): We’ve thrown out three bullish ETFs so far; how about one to avoid or short? With Energy prices headed through the roof again, investors are scurrying to put together an approach to profit on rising prices. or some, the knee-jerk move will be to go long stocks having anything to do with Energy — WRONG!
Click to Enlarge We just spent a few minutes talking about the neglected Regional Bank shares and the bullish potential of that neglect (identified by low analyst rankings). The current situation in the XOP represents the opposite, bearish, situation that should hold these stocks back through 2012.

Unlike the ETFs we’ve mentioned, the XOP shares have lagged the market in performance for the last three months as they’ve slipped into technically dangerous trading zones.

As of Friday, the shares were trading back below their 200-day moving average, a sign that the trading trend is moving against the bulls. Additionally, the 50-day moving average of the XOP shares is now shifting from an ascending pattern to a descent, a serious indication that the near-term trend is likely to continue.

Despite the technical struggles, the companies that make up the XOP shares remain among the MOST recommended group of stocks. Currently, the XOP is the ETF with the highest percentage of “buy” rated companies, with 60% of its 74 companies falling into the analysts’ favor.

The fact that there is so much bullishness towards a technically failing group of stocks suggests that XOP shares are at risk of seeing a flurry of downgrades, which would drive the XOP even further into technically failing territory. All of this and we haven’t even mentioned that the Presidential Election cycle is likely to put pressure on energy prices as we head through the year, a fundamental strike against these companies.

We like the odds that the XOP will finish the year below $50, indicating the shares shouldn’t have any place in your portfolio. Traders may wish to make a move on our forecast by taking a look at the XOP puts. Considering this a “hedge” against the rest of the market’s bullish opportunities, we would consider a slightly out-of-the-money option for the XOP shares. The September XOP 55 Put, currently trading under $6.00, will offer the opportunity to benefit from a continuation in the downside target for the XOP shares.

Trade #5: GDX

Another ETF that’s been high on investors’ bullish lists is the Gold Miners ETF (NYSE:GDX). Investors LOVE gold and almost anything associated with the yellow metal, however, that’s not always good as the “overloved” stocks are often those that trail the markets.
Click to Enlarge Since peaking in September 2011, gold prices have slowly initiated a decline as the 50-day moving average for the GLD has been transitioning into a declining pattern with the gold mining stocks following suit.

From a technical perspective, the GDX chart is amazingly bearish as the ETF experienced a “Death Cross” (indicated by the ETFs 50-day moving average crossing below its 200-day moving average) in November 2011 with many of the mining stocks following suit. Further proof of the mining companies’ technical failure can be seen in the fact that all but one of the companies that comprise the Gold Miners ETF are trading below their respective 50-day moving averages.

Technical failure of an investor-favored sector is a textbook recipe for continued weakness, which is why we’re of the opinion that the GDX shares don’t belong in the average investor’s portfolio. We like the January GDX 50 puts, currently trading around $7, as a hedge against the likely continued weakness in the Gold Miner ETF.

As of this writing, Chris Johnson holds an option in the XLY, but not the one referenced here.